Discounted Cash Flow Analysis for Real Estate Questions and Correct Answers
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Module
Discount Cash Flow
Institution
Discount Cash Flow
What 4 basic questions must be answered to understand any real estate investment? 1. How many dollars go into the investment?
2. When do the dollars go into the investment?
3. How many dollars come out of the investment?
4. When do the dollars come out of the investment?
Holding Period Usually ...
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Discounted Cash Flow Analysis for Real
Estate Questions and Correct Answers
What 4 basic questions must be answered to understand any real estate investment?
✅1. How many dollars go into the investment?
2. When do the dollars go into the investment?
3. How many dollars come out of the investment?
4. When do the dollars come out of the investment?
Holding Period ✅Usually shown in years on the left hand side of the cash flow
model/diagram. It is typically assumed that the time of the cash flows occur at the End
of the Year (EOY). In commercial real estate, this is typically between 5-15 years for the
purposes of financial analysis.
Initial Investment ✅Normally shown in time period zero (0) and includes all acquisition
costs required to purchase the asset, less any mortgage proceeds. In other words, this
is your total out-of-pocket cash outlay required to acquire a property.
Annual Cash Flows ✅Normally broken line-by-line in a real estate pro forma (cash flow
projection). It is the net result of gross income minus expenses and debt service. If this
is negative, it means dollars are going into the investment; if this is positive, it means
dollars are coming out of the investment.
Sale Proceeds ✅Represent the net cash flow received from the disposition of an
investment property. This cash flow item shows up in the last period of the holding of
the real estate cash flow model.
Discounted Cash Flow (DCF) Analysis ✅A technique used in finance and real estate to
discount future cash flows back to the present.
List, in order, the 3 steps for conducting a Discounted Cash Flow (DCF) Analysis for
commercial properties. ✅1. Forecast the expected future cash flows.
2. Establish the required total return
3. Discount the cash flows back to the present at the required rate of return.
Discount Rate ✅The rate used in a discounted cash flow (DCF) analysis to compute
present values.
, Cap Rate ✅The ratio of Net Operating Income (NOI) to property asset value.
It is a measure that quantifies property value per dollar of current net income.
Another way to think about: it is the inverse of the price-to-earnings (P/E) ratio
commonly used in stock markets.
So, for example, if a property was listed for $1,000,000 and generated an NOI of
$100,000, this value would be $100,000/$1,000,000, or 10%
The Cap Rate allows us to value a property based on a single year's NOI.
If a property had an NOI of $80,000 and we thought it should trade at an 8% Cap Rate,
what would its estimated value be? ✅$1,000,000
How is the Discount Rate different from the Cap Rate? ✅The discount rate is used to
determine value and account's for all years in the holding period, not just a single year
like the Cap Rate.
If a property's cash flows are expected to increase or decrease over the holding period,
then the Cap Rate will be a misleading performance indicator.
By completing a multiyear discounted cash flow analysis, we could quantify exactly how
much we can pay for this property with a Net Present Value (NPV), given the investor's
discount rate. The Cap Rate, on the other hand, will not be able to answer this question.
Net Present Value (NPV) ✅An investment measure that tells an investor whether the
investment is achieving a target yield at a given initial investment. It also quantifies the
adjustment to the initial investment needed to achieve the target yield assuming
everything else remains the same.
Formally, this is simply the summation of cash flows (C) for each period (n) in the
holding period (N), discounted at the investor's required rate of return (r)
Internal Rate of Return (IRR) ✅The percentage rate earned on each dollar invested for
each period it is invested. It is also another term people use for interest.
Ultimately, this gives an investor the means to compare alternative investments based
on their yield.
Mathematically, this is found by setting the NPV equation to 0 and solving for the rate of
return (r)
What's the difference in use between IRR and NPV? ✅IRR tells you the total return on
the project, given the projected cash flows.
NPV, on the other hand, tells you how much more or less your initial investment needs
to be in order to achieve your desired rate of return.
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